Some Commodity ETFs Carry Tax Risks

NOW THAT GOLD, oil and other commodities have pulled back from record highs, some investors might be tempted to buy on the dips. If you do — and that's a decision you'll need to make on your own — at least buy smart.

At first glance, a commodity ETF seems like an easy and cheap route to take. They're certainly popular: Since 2006, commodity ETFs have raked in some $20 billion in net inflows, and their assets now stand at $30 billion, according to Morgan Stanley analyst Paul Mazzilli.

The giant of the group is SPDR Gold Shares (GLD), which has a whopping $19 billion under its belt. United States Oil (USO) is far smaller at less than $1 billion, but it has bragging rights as the first pure-play oil ETF.

Financial advisors generally frown on these ETFs for retail investors, though, viewing them as speculative tools for making risky short-term bets. But if you love living dangerously, allow us to offer a more mercenary reason to be wary of commodity ETFs: taxes.

Not so long ago, at the height of the commodities bubble, tax implications were the least of investors' concerns because the profits were flowing so freely. But with gold and oil down more than 20% and many market watchers declaring an end to the commodities boom, profits are no longer plentiful. Enter the renewed focus on taxes.

With traditional ETFs that invest in stocks, you don't pay taxes on gains until you sell the fund thanks to a quirk in the ETF structure. This is one reason ETFs are taking market share from mutual funds, in which you have to pay capital gains taxes annually even if you hold the fund long term. But with commodity ETFs, it's a different story.

The reason is that many commodity ETFs don't own stocks but either the actual physical commodities themselves or derivatives such as futures contracts.

For ETFs investing in commodity futures, you must report gains each year to Uncle Sam even if you don't sell the ETFs. So there's no tax benefit to these babies. When you do pay, 60% of your gains are taxed at the long-term cap gains rate of 15% and 40% are taxed as short-term cap gains, which are taxed similarly to your ordinary income.

For ETFs investing in physical commodities, Morgan Stanley's Mazzilli points to three in particular: SPDR Gold Shares, iShares COMEX Gold Trust (IAU) and iShares Silver Trust (SLV). The rub with investing in actual gold and silver is that the IRS taxes them as collectibles, which get a higher long-term cap gains rate of 28%, not the lower 15% charged to stocks. ("Long term" means you hold it for at least a year.)

You should also be aware that the iShares and United States commodity funds are structured differently from many other ETFs, and could require you to pay taxes each year regardless of whether you hold or sell. "It can be burdensome for people after awhile" to figure it all out, says Morningstar analyst Paul Justice.

If you still want some commodity exposure, Justice recommends the iPath Dow Jones AIG Commodity Index (DJP). As an exchange-traded note, or ETN, rather than an ETF, it doesn't track commodity-related securities but instead holds a 30-year note from Barclays (BCS), which will pay the return of the DJ-AIG Commodity Index in exchange for an annual 0.75% fee. As of now, the ETN gets the same tax benefits we're used to with stock ETFs: You don't pay cap gains until you sell. Enjoy the break while it lasts.

Also See:
Long-Running Commodities Boom Goes Bust
Expensive ETFs Come With Liquidation Risk
120 New ETFs Debut So Far in 2008